Investing always involves a tug of war between safety and the desire for high returns. Right now, though, even if you're a value investor, an unusual dynamic makes it worth your while to take a look at stocks you might have rejected as being too risky.
A number of analysts have pointed out some valuation distortions between stocks seen as having defensive characteristics and the rest of the market. In particular, safety-conscious investors have bid up prices of stocks in less volatile industries, while leaving other sectors that are more tied to the ups and downs of the business cycle trading at a discount. If you're willing to take a contrarian view with your portfolio, you may be able to exploit those conditions to your advantage.
Fear overcoming greed
The motivation for why investors are willing to pay more for defensive stocks is obvious: they're scared of what may be coming down the pike for the stock market. With major indexes having doubled from their 2009 lows, many investors fear that with all the geopolitical and macroeconomic risks facing the world right now, the gains in the market over the past few years may prove all too short-lived.
As a result, risk-averse investors are looking to low-volatility names that tend to hold up better in down markets. For instance, both Coca-Cola (NYSE: KO ) and Southern (NYSE: SO ) have volatility figures less than half of the overall market, yet they've enjoyed gains that nearly match the S&P's return over the past year. But profits haven't kept up, and so the stocks sport higher earnings multiples -- 21 for Coke and 19 for Southern -- which is not exactly bargain territory.
At the same time, though, investors who are fearful of a renewal of economic weakness are in no hurry to run out and buy economically sensitive stocks. You can therefore find what look like sweet deals on some stocks of cyclical companies that appear to be priced for a big economic contraction. Here are a few.
Freeport-McMoRan Copper & Gold (NYSE: FCX )
When it comes to predicting economic activity, many investors believe that copper is king. And when you think about copper, Freeport-McMoRan is an obvious choice, with solid reserves of copper, gold, and other important metals. The company is a leader within the mining industry.
Investors have bid down Freeport-McMoRan shares because of slowdowns in construction activity and industrial growth. Yet with the stock trading at just seven times forward earnings estimates, and just over 10 times trailing earnings, investors have a huge margin of safety against any slowdown that may come.
Chesapeake Energy (NYSE: CHK )
Similarly, energy stocks have gotten punished by fears of economic weakness. As overall activity decreases, the need for energy also goes down, and that comes back to punish the prices that determine how profitable companies like Chesapeake are.
Of course, Chesapeake has its own unique problems related to management. But as scary as those problems may appear, the stock currently trades at six times trailing earnings, and even though profits are expected to take a huge hit this year and next, the valuation is still fairly attractive. Combine that with the prospect that natural gas prices may have bottomed and that activist investors may unlock more of the natural gas giant's value, and you have a reasonable bull argument for Chesapeake.
CSX (NYSE: CSX )
One area of the market that hasn't risen to new highs is transportation. Despite the advantages of rail transport over less-energy-efficient alternatives like trucking, the slowdown in coal transport stemming from Asia's decelerating growth has had an impact on CSX and its peers.
In particular, CSX trades for just 13 times trailing earnings and 11 times forward estimates, yet it pays a 2.5% dividend that it covers easily with net income. More importantly, it's working hard to diversify its customer base and find ways to soak up excess capacity. Even in a recession, people won't stop needing the things that CSX transports, and that should help put a floor under the stock no matter what happens.
When markets are choppy, it's always tempting to stick to safe picks. But when the market offers you bargains, you really need to take advantage of them. For opportunistic investors, these three somewhat aggressive picks should do you more good over the long haul than high-priced names in more traditionally defensive sectors of the market.
Another place to look for smart picks is where Wall Street typically doesn't look. We've found three hidden treasures, and we're naming names in our latest special report: "3 Middle-Class Millionaire-Maker Stocks." It's free and waiting for you.